On February 16, 2010, CMHC announced changes to the treatment of rental income when calculating a borrower’s total debt service ratio (TDS) for mortgage loan insurance applications.

The purpose of this post is to provide additional detail with respect to this calculation and the documentation that can be used to support rental income.

Clarification of the Treatment of Rental Income from Residential Properties

Effective April 19, 2010 CMHC’s TDS formula will change as follows:

PITH¹ + Other Debt
Borrower’s Gross Annual Income

¹ PITH means principal, interest, property taxes and heat

If the subject property generates rental income, then:
·     50% of gross rents can be included in the borrower’s income; and
·     T + H for the property generating rental income can be excluded.

If rental income from another property where the borrower resides is being used to support the application, then:
·     50% of gross rents can be included in the borrower’s income; and
·     T + H for the property generating rental income can be excluded.

If the borrower has other non-owner occupied, rental income generating residential properties, then:
·     net rental income can be included in the borrower’s income; and
·     PITH for these properties can be excluded from the debt service costs.

50% of condominium fees must be included, when applicable. For chattel or leasehold loans, 100% of site or ground rents must be included.

Clarification of Net Rental Income
Net rental income may be determined by using the borrower’s Canada Revenue Agency T776 Statement of Real Estate Rentals form as a guide for expenses.

If the lender is using the net rental income from the borrower’s income tax return, the figure can be grossed up by 15% only if deductions have been taken to depreciate or amortize capital assets. The 15% gross up can also be applied to rental income if the borrower has taken self-employed deductions associated with the rental income that were not included in the Statement of Real Estate Rentals form such as business use of home or motor vehicle expenses, only if the income has not already been grossed up by 15% to offset the depreciation or amortization of capital assets.

Alternatively, the lender can use their own internal guidelines for determining the net rental income. Net rental income is to include gross rents less operating expenses and at least the interest portion of any loan payment that is secured by a mortgage on the property. Operating expenses should include factors for management expenses where applicable as well as vacancy and maintenance.

Similar to CMHC’s guideline for self-employed income, Lender’s are required to use the average of the most recent 2 years net rental income to ensure the income level is stable. If the lender is confident that rental income is stable, the current net rental income can be used.

Implementation
The TDS formula detailed in this note will apply to transactional and Portfolio applications for mortgage loan insurance at all loan to values, submitted to CMHC on or after April 19, 2010 for loans that will be funded on or after April 19, 2010.

CMHC will consider exceptions to the requirements described in this note where the Approved Lender has documentation that the borrower has a legally binding purchase and sale, financing or refinancing agreement dated before April 19, 2010 and the closing date occurs on or after the effective date.

Suppose we agree that we would like our society to have widespread home ownership and a property-owning citizenry. Does it take government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac with implied taxpayer guarantees, tax advantages for the interest paid on home mortgages, and government pressure for “creative” mortgage lending to achieve this? The Canadian experience shows that it doesn’t.

Canada makes a useful comparison for the U.S. Both countries are rich, advanced, stable, have sophisticated financial systems and pioneer histories, and stretch from Atlantic to Pacific. But Canada has no housing GSEs. Mortgage interest is not tax deductible. It does not have 30-year fixed rate, freely prepayable mortgage loans.

Mortgage lending is more conservative and much more creditor-friendly. Canadian mortgage lenders have full recourse to the mortgage borrower’s other assets and income, in addition to having the house as collateral. This means there is little incentive for borrowers to “walk away” from their mortgage. The absence of a tax deduction for mortgage interest probably increases the incentive to pay down debt. Most Canadian mortgage payments are made through automatic debit of the borrower’s checking account—a technical but important point. Canadian fixed-rate mortgages typically have prepayment penalties to protect the lender and the interest rate on the loan is fixed for only up to five years.

This relative creditor conservatism has meant that Canada and Canadian banks have so far come through the international financial crisis in much better shape than their U.S. counterparts. Canada didn’t avoid the recession, but mortgage delinquencies have so far remained much lower than in the U.S., with the percentage of loans delinquent 90 days or more at approximately one-tenth of the U.S. level.

What about the home ownership rate—the percentage of all households owning their own home? Isn’t there a home ownership price to pay for this Canadian credit conservatism? No.

Here’s the home ownership rate in Canada: 68%. In the U.S. it’s 67%. The U.S. rate peaked at the top of the housing bubble at 69%. In other words, two very different housing finance systems, one much riskier than the other, produced virtually the same home ownership rate.

This must cause us to call into question longstanding U.S. beliefs about the relationship of government-subsidized housing finance to home ownership.

The former savings-and-loan industry justified its special tax and regulatory privileges, including its right to pay more interest on deposits than commercial banks were then allowed to, by appealing to its role in home ownership. Then came the savings and loan collapse of the 1980s.

Fannie Mae and Freddie Mac took over the home ownership mantra. In the vast risk expansion of their arrogant days, with very high rates of profitability made possible by government-granted privileges, they justified these privileges by appealing to home ownership. It was often said by their supporters that the GSE-dominated U.S. housing finance system generated the highest home ownership rates in the world, which was false, and that this system was the “envy of the world,” which was also false. Fannie Mae’s annual reports regularly featured a house with an American flag flying.

Now it is clear to everyone that Fannie and Freddie, having done so much to help inflate the bubble and having been dragged into insolvency by its deflation, are wards of the government. The taxpayer bailout of these GSEs is likely to cost much more than the bailout of the saving and loans did a generation ago. The U.S. Treasury has unilaterally signed the taxpayers up for unlimited support of these bankrupt purveyors of government-advantaged mortgage finance.

So the widespread previous beliefs about the desirability of having GSEs were wildly mistaken. It ought to be clear by now that an entity can be a private company with market discipline, or it can be a government body with governmental discipline, but it can’t be both.

In this context, it is important to recognize that Canada does have a government body to promote housing finance: the Canada Mortgage and Housing Corporation (CMHC), which is the dominant credit insurer of mortgages in the country. Whether or not you like the idea of such a government financing operation, at least its status is perfectly clear and honest. The Canadian government owns 100% of its stock. Its guaranty from the government is explicit. It provides housing subsidies which are on budget and must be appropriated.

Let’s remember that the original sin of making Fannie a GSE in 1968 was to get it off the federal budget so the deficit looked smaller. Canada in this respect looks superior to the U.S. in candor as well as credit performance.

By Alex J. Pollock, resident fellow at the American Enterprise Institute in Washington, D.C.
Mr. Pollock was president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.

On Mar. 23, Louis Gagnon, a finance professor at Queen’s School of Business and a former senior manager in risk management at the Royal Bank of Canada, published an article at the Globe and Mail, aptly called: “Why we need tougher mortgage rules“, in which the author hinted that:

“It’s time to pay our debt, not go further into it. A nudge from Ottawa couldn’t hurt”

Among the arguments used by Gagnon, we read the following:

“In Canada, more risky mortgages (those with a down payment of less than 20 per cent) are insured by the Canada Mortgage and Housing Corp., whose chief mandate is to “promote” home ownership. As long as CMHC is willing to “insure” the mortgages, there’s no stopping less picky lenders from lending. Essentially, CMHC provides a back door through which low-quality mortgages can creep into the system. And if something goes wrong and CMHC can’t absorb the losses, who will have to foot the bill? You guessed it: We will.

As long as CMHC is configured this way, the system remains vulnerable to the games the few are willing to play at the expense of the many. This explains why the Big Five insisted Ottawa handcuff the entire industry with tougher rules.”

And below you can read the comment we have selected, from the many that sprouted up regarding that article.

“The arguments against the Canada Mortgage and Housing Corp. (Why We Need Tougher Mortgage Rules – March 24) are fascinating in that they criticize the institution for insuring “risky mortgages,” while ignoring that CMHC has pledged to purchase billions in mortgage portfolios from lenders since the beginning of the credit crisis in 2008. This measure provided much-needed liquidity for mortgage lenders big and small. Now that the crisis has seemingly passed, the Big Five banks are exerting political pressure on the federal government to “rein in” CMHC, as if that institution were to blame for the global liquidity crisis.

Obviously, it was the business practices and risk management of global banks, including our own, that brought our international financial system to near collapse. CMHC intervention has been a major factor in bank profits since 2009. The banks’ own lax standards in providing credit to Canadians, while profiting from those practices, have put our country in its current debt-laden state.”

by Bruce Flanagan